Product market competition and the value of corporate cash: Evidence from trade liberalization

Journal of Corporate Finance 25 (2014) 122–139

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Product market competition and the value of corporate cash: Evidence from trade liberalization☆ Azizjon Alimov ⁎ Department of Economics and Finance, City University of Hong Kong, Kowloon Tong, Hong Kong

a r t i c l e

i n f o

Article history: Received 15 November 2012 Received in revised form 12 November 2013 Accepted 19 November 2013 Available online 26 November 2013 JEL classification: D43 F14 F15 G32 G34

a b s t r a c t This paper uses the 1989 Canada–U.S. Free Trade Agreement as a source of exogenous variation in product markets to establish the impact of increased competition on the market valuation of corporate cash reserves. I find that the trade liberalization leads to a significant increase in the value of cash for firms experiencing a larger shock to their competitive environment. The impact of the trade liberalization is stronger among firms that face greater risk of losing investment opportunities to rivals. I also show that these inferences about the valuation effect of competition apply more broadly to a large sample of firms. © 2013 Elsevier B.V. All rights reserved.

Keywords: Competition Trade liberalization Cash holdings Firm value

1. Introduction It is widely recognized that important corporate decisions are fundamentally affected by competition in product markets. In particular, finance scholars have shown that the nature of product market competition influences firms' financing and investment choices and, therefore, their cash flows (e.g. Haushalter et al., 2007; Xu, 2012). Hou and Robinson (2006) and Hoberg and Phillips (2010) further document a significant effect of competition on the riskiness and market valuation of these cash flows. To date, however, relatively little is known how competition affects the market valuation of important corporate policies, such as cash management. This is a surprising gap in the literature given a tremendous increase in cash holdings of firms in the U.S. over the last three decades and the massive value gains or losses to investors that can result from firm cash management choices (e.g. Bates et al., 2009). Over that same period, firms have experienced a significant increase in the intensity of competition due to globalization of business activity, reductions in trade barriers, and technological progress. Therefore, it is important to understand the effect of increased competition on the contribution of cash holdings to firm value. The goal of this study is to examine whether and how changes in the intensity of competition faced by firms affects the value of their cash holdings. To establish a convincing link between competition and the value of cash, however, a researcher needs to deal with the fact that many commonly used proxies for competition, such as industry-level concentration ratios or profit margins, are difficult to ☆ I thank Sudipto Dasgupta, Wayne Mikkelson, Sandy Klasa, Boris Nikolov, Yen-Teik Lee, Mian Mujtaba and seminar participants at University of Arizona, 2009 California Corporate Finance Conference, 2010 City University of Hong Kong International Conference on Corporate Finance, 2011 Asian Finance Association annual meeting, and 2012 China International Conference in Finance for helpful comments on earlier versions of this paper. I owe special thanks to an anonymous referee for suggestions that led to a substantially revised and improved paper. All errors are mine. ⁎ Tel.: +852 3442 2168. E-mail address: [email protected]. 0929-1199/$ – see front matter © 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.jcorpfin.2013.11.011

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interpret due to the endogeneity of industry structure to firms' chosen financial and investment policies (Schmalensee, 1989). I attempt to deal with this endogeneity problem by using the Canada–United States Free Trade Agreement (FTA) as a source of an exogenous change in firms' competitive environment. The FTA came into effect in 1989 and involved substantial reductions in tariffs and other trade barriers between the two countries, and thus significantly reduced entry barriers into a large number of industries. As discussed by Trefler (2004), the FTA represents a clearly defined trade policy experiment which was exogenous to individual companies and was not driven by changes in economic climate or political climate. As a result, this trade agreement plausibly represents a substantial exogenous shock to firms' competitive environment and allows me to assess the causal impact of increased competition on the value of cash. I further exploit the cross-sectional differences in the impact of the competitive shock across firms based on their exposure to trade with Canada. Specifically, my empirical analysis isolates the effect of the trade agreement by studying its differential impact on the value of cash across firms, based on the degree to which firms were protected by tariffs on Canadian imports prior to the agreement. The identifying assumption of this empirical strategy is that firms that experience larger import tariff reductions as the result of the FTA (and thus greater decline in entry barriers into their industries) should be exposed to a greater increase in foreign competition. Using a large panel data that spans the period from 1984 to 1995, I conduct difference-in-differences tests, in which I compare the market valuation of cash reserves before and after the trade liberalization (first difference) for firms experiencing relatively large versus small tariff cuts due to the FTA (second difference). I find a significant value impact of an increase in competition due to the decline in tariffs. Following the trade liberalization, the value of an additional $1 of cash increases, on average, by $0.59 more for firms that experience relatively large tariff cuts due to the FTA relative to the value of cash for firms that experience smaller tariff cuts. This effect is estimated controlling for all other factors that may affect the marginal value of cash as well as firm and year fixed effects that account for permanent unobserved firm heterogeneity and economy-wide factors. To reduce concerns about reverse causality, I trace out the timing of the effect of the trade liberalization and find that its effect manifests only two years after the passage of the agreement. It is important to note that the FTA eliminated U.S. tariffs on Canadian imports as well as Canadian tariffs on U.S. exports and thus increased growth opportunities for U.S. firms. I examine the effects of increased market expansion opportunities and find that the reductions in Canadian tariffs on U.S. exports have no significant effects on the value of cash. Overall, the results point to the positive and causal effect of increased competition in firms' product markets due to the trade liberalization on the value of firms' cash reserves. After establishing the average valuation effect of increased competition, I next attempt to understand the mechanism through which changes in competitive environment impact valuation. To do so, I turn to theories of predation or competitive threats and agency conflicts for the insight into the links between competition and the use of corporate cash (which ultimately determines its value to investors). Predation threat-based theories stress the strategic role that cash reserves play in ensuring a firm's ability to successfully compete in product markets. For instance, Bolton and Scharfstein (1990) and Froot et al. (1993) show that a firm's stockpile of cash provides an important source of flexibility in product markets because cash allows the firm to effectively counter possible predatory threats by their rivals or to even prevent entry of new competitors. The predation threat view thus implies that a rise in foreign competition will increase the value of corporate liquidity through an increase in the level of competitive threats faced by firms in their product markets. In contrast, the agency-based theories suggest that stockpiles of cash can exacerbate agency conflicts at the firm by providing self-interested managers with discretionary funds to undertake suboptimal investment (e.g. Jensen, 1986). Dittmar and Mahrt-Smith (2007) show that investors indeed discount the value of cash reserves in firms run by potentially entrenched managers. Economists have long argued that the competitive pressure from product markets serves as a powerful tool to mitigate agency problems. Tougher competition enforces discipline on managers to reduce inefficiency, or else be driven out of business. The agency-based view thus implies that a rise in competition will increase the value of corporate cash by reducing the discount associated with the agency problem of cash holdings. Although the two theories are observationally equivalent with respect to the impact of increased competition on the value of cash, their predictions on the specific mechanisms through which competition impacts valuation are different. Specifically, the predation risk view predicts that the impact of the trade reform on the value of cash will be stronger among firms that share a larger proportion of their growth opportunities with existing rivals and thus have more to gain by using their cash to combat new product market threats. In contrast, the agency view suggests that an increase in competition will have a stronger impact on the value of cash among firms that have weaker governance mechanisms in place and thus have more to gain from a disciplining effect of increased competition. To determine the relative merits of these competing explanations, I conduct two sets of tests. I first test whether the effect of the FTA-mandated tariff reductions on the value of cash varies systematically with the firms' exposure to predation threats and the severity of agency problems before the event. The idea here is that one can study the heterogeneity of changes in the value of cash across firms to understand which mechanism, on average, is considered to be more important by the market. I find that the large FTA tariff reductions have a stronger impact on the value of cash for firms facing greater predation threats, as measured by proxies for the interdependence of their growth opportunities with rivals. In contrast, I do not find that the impact of the trade liberalization is stronger among firms with weaker governance, as measured by proxies for the presence of large institutional monitors. In the second test, I look whether firms change the use of their cash reserves for investment purposes following the trade liberalization. The predation and agency views imply that an increase in competitive pressure will potentially have two opposing effects on the use of cash for investment. One possibility is that firms spend more of their cash reserves on investment in an attempt to counter increased competitive threats from foreign rivals or deter entry. Alternatively, if competition enforces discipline on opportunistic managers, firms may cut wasteful spending when faced with growing competitive pressure. I find that firms with a greater increase in competitive pressure (i.e. firms with larger FTA tariff reductions) spend more of their cash

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reserves on capital expenditures and R&D expenditures. A caveat to this result is that the test design cannot directly attribute the increased spending to the firm's deliberate attempt to manage predatory threats. Bearing this caveat in mind, these last sets of findings potentially highlight the predominant role of increased predation threats in explaining the increase in the value of cash in the wake of the trade liberalization. In the final set of tests, I use alternative proxies for the intensity of competition and show that my inferences about the impact of competition on the value of cash from the quasi-natural experiment apply more broadly to a large sample of Compustat firms. 2. Theoretical background and related empirical studies This section starts by describing the predation threats-based and agency-based theories that explain why changes in firms' product market conditions may affect the value of their cash holdings. I then discuss the empirical implications and related empirical studies.

2.1. Increase in competition, predation threats, and value of cash A number of theoretical studies argue that a stockpile of cash confers important strategic advantages to firms in product markets and thus increases shareholders' wealth. In particular, Telser (1966) initially proposed and Bolton and Scharfstein (1990) formalized a “deep pockets” argument that a firm's ability to compete successfully against its product markets rivals depends on the level of internal liquidity. Bolton and Scharfstein argue the advantage of having sufficient internal liquidity is that it provides important flexibility to firms in competitive product markets. Specifically, cash allows a firm to react more aggressively to competitive or “predatory” actions of their product market rivals or to create barriers to entry for potential new rivals. Froot et al. (1993) further propose that a firm's exposure to the predation threats and thus the competitive advantage of having cash is largely determined by the nature of competitive interactions within the firm's product markets. They suggest that having additional cash is more valuable when product market rivals compete in strategic substitutes and thus have a high degree of interdependence in their investment opportunities. If a firm is not able to internally finance its valuable investment opportunities, it risks losing these opportunities and market share to rivals. Collectively, the predation threat-based theories suggest that having additional internal funds, which allow a firm to effectively combat competitive moves of its product market rivals, serve shareholders' interests. Under the predation view, a rise in competition increases the competitive threats faced by a firm and thus raises the value of its cash holdings which the firm can use to combat these threats. 2.2. Increased in competition, managerial agency problems, and value of cash The alternative argument linking changes in product market conditions and the value of cash emphasizes the disciplinary role of competition in mitigating managerial slack, such as inefficient use of cash reserves. A prevalent view among researchers and practitioners is that large cash reserves aggravate the agency conflicts between managers and shareholders. Easterbrook (1984) suggests that cash reserves allow managers to avoid the scrutiny and monitoring of outside investors. Jensen (1986) argues that self-interested managers would spend excess cash holdings on projects that benefit them rather than shareholders. Consistent with the idea that agency conflicts influence the value of cash, Dittmar and Mahrt-Smith (2007) and Masulis et al. (2009) find that investors place a much lower value on cash holdings in firms with weaker corporate governance structures, as indicated by the preponderance of antitakeover provisions and greater control rights-cash flow rights divergence. Harford et al. (2008) further show that firms with more entrenched managers tend to spend cash on value-reducing projects. Economists have long argued that tough competition in the product market can be an even more effective force for mitigating managerial agency problems than internal corporate governance structures. Alchian (1950) and Hart (1983) argue that competitive pressures in the product market force firms to minimize costs and increase operating efficiency, and drive inefficiently run firms out of the market. Shleifer and Vishny (1997) note that, “product market competition is probably the most powerful force towards economic efficiency in the world.” The agency view thus suggests that an increase in competition can increase the value of cash to shareholders by forcing managers to use cash more efficiently and thus reducing agency costs associated with cash holdings. 2.3. Empirical implications The discussion above highlights several empirical implications. First, both theories imply that a decline in entry barriers due to the trade liberalization and subsequent increase in competition will raise the value of corporate cash on average. However, the predation risk and agency theories rely on different mechanisms and thus have distinct predictions as to through which channel an increased competition will impact the value of corporate cash. Specifically, the two theories have different predictions about the type of firms most likely to benefit from having an extra dollar of liquidity when their competitive environments are undergoing a major change. The predation view suggests that a rise in competition will have a stronger influence on the valuation of corporate liquidity among firms for which the emergence of new competitive threats is more likely to threaten their market position, such as firms that already share more of their investment opportunities with industry rivals. In contrast, the agency view

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predicts that, a rise in competition will have a stronger impact on the value of cash resources among firms that stand to gain the most from the disciplining role of increased competition, such as firms with weaker governance mechanisms in place. Therefore, this paper attempts to identify the relative importance of each mechanism by examining heterogeneity in the value impact of increased competition across the predation threat and the corporate governance dimensions.2

2.4. Contribution and related empirical studies This paper contributes to the literature by identifying an important channel through which changes in product market competition affect shareholder wealth—the market valuation of cash reserves. This study goes beyond simply establishing an association between static proxies for competition and market valuation and instead documents a causal effect of an increase in competitive pressure. Consequently, this paper advances our understanding of the precise links between competition and the value implications of corporate policies. These findings add to a growing body of evidence showing a link between product market competition and shareholder wealth. Hou and Robinson (2006) and Hoberg and Phillips (2010) show that competition systematically affects average stock returns. Gaspar and Massa (2006) and Irvine and Pontiff (2009) provide evidence that increased competition over the past few decades contributed to increased volatility of firms' cash flows and stock returns. Giroud and Mueller (2011) find that the positive link between good internal governance and stock returns exists only in noncompetitive industries. The findings in this paper also add to the growing literature which studies the determinants of the market valuation of corporate cash resources. Prior studies mostly focused on firm characteristics to explain cross-sectional variation in the value of cash, such as financial constraints (Faulkender and Wang, 2006), managerial agency conflicts (Dittmar and Mahrt-Smith, 2007; Masulis et al., 2009), labor unions (Klasa et al., 2009), country-level investor and creditor protection (Pinkowitz et al. 2006; Kyröläinen et al., 2013), firm diversification (Tong, 2011), and managerial compensation incentives (Liu and Mauer, 2011). In contrast, this is the first study that demonstrates an important role of product market competition in determining the value of corporate cash. Finally, this paper is related to the literature on the effects of firms' chosen cash positions on product market outcomes. Haushalter et al. (2007) show that firms' cash holding and hedging policies are closely related to the industry structure and the extent of the interdependence of their investment opportunities with rival firms. Consistent with the predation models, the authors show that larger cash reserves allow firms to support their investment spending at times when their rivals are forced to cut their investment spending. Fresard (2010) examines the effects of cash holdings on firm performance in product markets and finds that firms with larger cash reserves tend to experience higher sales growth and operating performance than their industry counterparts. Using large industry-level import tariff cuts to measure changes in competition, Fresard confirms that firms with larger cash holdings achieve higher industry-adjusted sales growth when foreign competition intensifies. Hoberg et al. (forthcoming) develop a new measure of product markets threats – product fluidity – and show that it influences firms' payout policies and cash holdings. Relative to this literature, the primary focus of my paper as well as its incremental contribution is to identify a causal impact of increased competition due to an exogenous fall in trade barriers on the market value of corporate liquidity. It is worth stressing that the value that the market places on the corporate cash is ultimately determined by how the market expects the cash to be utilized. Hence, studying changes in the value that investors attach to the cash holdings of firms allows me to capture the market's comprehensive estimate of how the value and implied use of the cash change following a shock to firms' competitive environment. In addition, the methodology used in this study to determine the market value of cash accounts for the potential shifts in the risk related factors due to unexpected changes in competition.

3. Identification and empirical strategy 3.1. The 1989 Canada – U.S. Free Trade Agreement A major obstacle hindering most empirical studies of the effect of competition on corporate policies and their value implications is the endogeneity of common competition measures. For example, Demsetz (1973) notes that a concentration index for a particular industry, a commonly used proxy for competition, may be the consequence of the efficiency of firms in that industry rather than the accurate measure of the intensity of competition. To identify the causal effect of competition on the value of the cash reserves of firms, I thus need to identify a setting, that from any individual firm's perspective, represents an exogenous, unanticipated and material shock to the firm's competitive environment. To this end, I identify a quasi-natural experiment that affects competition through its effect on imports tariffs and other trade barriers. Import tariffs represent an important mechanism that countries use to protect domestic producers from foreign competition. The quasi-natural experiment in this paper exploits the elimination of all tariffs and other trade barriers between Canada and U.S. across a large number of industries. The tariff reductions were the result of the Canada–U.S. Free Trade Agreement (FTA), which was signed in 1988 and went into effect in January 1989. Trefler (2004), Guadalupe and Wulf (2010), Romalis (2007), Bernard et al. (2011), among others, used this event to identify exogenous changes in product market 2 I acknowledge that the theoretical mechanisms for the effect of competition require a number of specific conditions as well as that both mechanisms may be operational within the same firm.

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competition. These papers discuss in detail the validity of this quasi-natural experiment for the identification of the causal effects of increased competition. I will thus briefly discuss the trade agreement here but I refer the interested reader to Trefler (2004) and Guadalupe and Wulf (2010) for discussion of the political and economic context in which the agreement was passed. Trefler (2004) points out that the FTA represented a clearly defined change in bilateral trade relations and that the trade reform was not accompanied by other economic or political reforms in the two countries. Trefler specially notes that the FTA was not implemented as a response to changes in macroeconomic conditions in the U.S. or Canada or as a result of pressure from any individual firm. Since major Canadian political parties opposed to the agreement, the eventual implementation of the FTA was highly uncertain and unanticipated. Only a narrow victory of the Conservative Party of Canada in the November 1988 general elections assured the passage of the FTA. Guadalupe and Wulf (2010) further note that relative to an alternative strategy that relies on large import tariff cuts, the FTA more cleanly identifies a truly exogenous change in competition. The timing of actual import tariff cuts can reflect endogenous choices of firms that may lobby governments for protection from foreign competition. To demonstrate that the FTA represented a substantial shock to the competitive environment of U.S. firms, Fig. 1 plots the percentage annual changes in the value of import shipments from Canada to the U.S. from 1986 to 1995. The trade data come from the Center for International Data at UC Davis. To illustrate the importance of changes to entry barriers into an industry due to a decline in tariffs, I divide industries into three groups based on the pre-1989 tariff levels that shielded these industries from Canadian imports. The pre-FTA tariffs and thus post-FTA tariff reductions at the four-digit SIC industry level ranged from zero to 36%. Industries with the pre-FTA import tariffs in the top tercile of the tariffs distribution (tariffs in excess of 5%) are denoted as the high tariff and industries with tariffs in the bottom tercile (roughly 2%) are denoted as the low tariff industries. All other industries are the medium tariff industries. As a whole, the volume of Canadian imports to U.S. almost doubled between 1986 and 1995. Fig. 1 further shows that the greater the industry-level pre-FTA tariff (and thus greater the tariff cuts mandated by the FTA) the faster the imports from Canada grew. Specifically, in industries that prior to the FTA were protected by tariffs in excess of 5%, the volume of Canadian imports has risen by about 300% from its 1986 level to 1995. In comparison, industries with import tariffs below 2% experienced a 122% increase in the volume of Canadian imports. The results in Fig. 1 thus indicate that the removal of trade barriers has substantially increased the presence of Canadian products, especially in industries with relatively high tariffs on Canadian imports before 1989. Romalis (2007) reports similar findings. Such a dramatic increase in the market penetration of Canadian products was likely to intensify competitive pressure on U.S. firms in part because Canadian firms tend to specialize in the same products and have skills similar to those of U.S. firms. I thus conclude that the decline in imports tariff mandated by the FTA represented economically meaningful competitive shocks for a large number of U.S. firms. 3.2. Empirical strategy and main regression The empirical strategy of this study uses a differences-in-differences method, in which I compare the value that the market places on the cash holdings of firms in the years before and after the FTA implementation (first difference) for firms experiencing greater versus-lesser increase in the competitive pressure due to the trade liberalization. While the FTA has affected a large number of U.S. industries, my empirical analysis follows Guadalupe and Wulf (2010) and Bernard et al. (2011) and attempts to isolate the impact of the trade liberalization by examining its differential impact on the value of cash across firms according to the level of tariffs that shielded these firms from Canadian imports before 1989. The identifying assumption central to this empirical strategy is that the FTA resulted in

Fig. 1. Change in the volume of US Imports from Canada between 1986 and 1995: by the level of pre-FTA tariffs. This figure shows the percentage changes in the volume of Canadian imports between 1986 and 1995 (relative to the level of imports in 1986) at the four-digit SIC industry level. The industries are divided into three groups based on their pre-1989 tariff rates on Canadian imports. Industries with import tariffs above the 67th percentile of the tariffs distribution (roughly 5%) are denoted as the high tariff and industries with import tariffs below the 33rd percentile (about 1.8%) are denoted as the low tariff industries. The industries in the medium tercile are classified as the medium tariff.

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a greater increase in competitive pressure for firms with higher pre-FTA Canadian tariffs relative to firms with lower tariffs. Findings in Fig. 1 as well as evidence in Trefler (2004) and Guadalupe and Wulf (2010), support this identification assumption. To identify the firms' differential exposure to the competitive shock, I create a dummy variable (“High Import Tariff”) that equals one if the firm experiences tariff reductions following the FTA in excess of 5%, which roughly corresponds to the top tercile of the tariffs distribution, and zero otherwise. I use a dummy variable instead of continuous measure to allow for more intuitive economic interpretation of the estimated coefficients. In addition, the binary variable should mitigate any measurement problems associated with the measurement of tariffs as effective rates (computed from trade data) instead of statutory rates. It is also necessary to point out that while all tariffs on imports from Canada were scheduled to go to zero after 1989 and some tariff reductions took effect in 1989, other tariffs were phased out over the ten year period. To avoid the fact that the tariff phase-out schedule could be endogenous, I follow Guadalupe and Wulf (2010) and treat all industries equally by exploiting only their pre-1989 level of tariffs. Since all tariffs were eliminated due to the agreement, the level of tariffs before the agreement represents the actual tariff reductions experienced by firms following the FTA. My primary regression model builds on the widely-used methodology developed by Faulkender and Wang (2006), which examines an association between a (unexpected) change in cash holdings and a (unexpected) change in the market value of equity over the fiscal year. The change in market value of equity is measured by the risk-adjusted equity return during fiscal year. The risk-adjusted return is the raw stock return minus the return on one of the 25 Fama and French (1993) size and book-to-market portfolio to which a firm belongs at the beginning of fiscal year. The following equation describes the differences-in-differences regression: ΔCashi;t ΔCashi;t ΔCashi;t þ γ2 postFTA  HighTarif f i  þ γ3 postFTA  MVi;t‐1 MVi;t‐1 MVi;t‐1 ΔCashi;t ΔEi;t ΔNAi;t ΔRDi;t þγ 4 HighTarif f i  γ 5 postFTA  HighTarif f i þ γ 6 þ γ7 þ γ8 MVi;t‐1 MVi;t‐1 MVi;t‐1 MVi;t‐1 ΔIi;t ΔDi;t Cashi;t‐1 NF i;t Cashi;t ΔCashi;t‐1 þγ 9 þ γ10 þ γ11 þ γ 12 þ γ13 Lit þ γ 14 MVi;t‐1 MVi;t‐1 MVi;t‐1 MVi;t‐1 MVi;t‐1 MVi;t‐1 ΔCashi;t þγ 14 Lit þ ϕt þ ηi þ eij;t MVi;t‐1 B

ri;t ‐Ri;t ¼ a þ γ 1

ð1Þ

The dependent variable is the risk-adjusted stock return. For the independent variables, ΔXi,t indicates a change in variable X for firm i over the fiscal year t. ΔCash is a firm's unexpected change in cash and marketable securities over the fiscal year, where the firm's cash position at the year-beginning serves as its expected value at the end of the year. All independent variables, except for leverage and competition, are scaled by MVi,t − 1, a firm i's market value of equity at the end of the fiscal year t − 1. Therefore, the slope on ΔCash captures the dollar change in the market value of equity of a firm for a one dollar change in its cash balance. PostFTA is a dummy variable that equals 1 for observations in the post-1989 period, and 0 otherwise. High Import Tariffi is a dummy variable that equals 1 if a firm is experiencing the FTA-mandated tariff reductions in excess of 5%, and zero otherwise. Other independent variables include: earnings before extraordinary items (E), change in noncash assets (NA), research and development expense (RD) (set equal to zero if missing), interest expense (I), common dividends (D), Leverage measured as long-term debt plus short-term debt divided by the market value of assets at time t (L), and net new finance measured as total equity issuance minus repurchases plus debt issuance minus debt redemption (NF). All regressions include firm fixed effects (ηi) to remove unobservable permanent firm-specific characteristics that could be correlated with both the tariffs and the valuation of firms' financing policies. The estimated value impact of the exogenous change in competition therefore is identified using the within-firm variation in their exposure to the trade liberalization. In addition, the specifications also include year fixed effects (ϕt) to control for year-specific economy-wide factors. The inclusion of firm and time fixed effects further alleviates the concern about omitted variables. The estimated standard errors in all specifications are corrected for heteroskedasticity and clustering at the firm level to account for potential within-firm error term correlations. The main variable of interest is the change in cash position by itself and the two key interactions of change in cash with the indicator variables for firms experiencing high vs. low tariff reductions due to the FTA. The coefficient on ΔCash*PostFTA*High Import Tariff measures the change in the marginal value of cash following the trade liberalization for the firms experiencing relatively large tariff cuts due to the FTA (in excess of 5%) relative to the firms experiencing relatively small or no tariff cuts for which the post-FTA change in the value of cash is captured by the slope on ΔCash*PostFTA. The regression also includes an additional interaction ΔCash*High Import Tariff (“the treatment”), which controls for the overall difference in the value of cash between firms with high and low levels of exposure to the trade liberalization. 4. Data and summary statistics 4.1. Tariff data I extract data on the volume of imported and exported goods and services and collected import duties aggregated at the four-digit SIC industry level from the Center for International Data at the University of California Davis (available on http://www.internationaldata.org).

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For each industry, I compute the effective pre-FTA tariff rates on imports from Canada as total duties collected by the U.S. Customs divided by the total value of imports from Canada between 1986 and 1988. The average pre-FTA U.S. tariff rate on Canadian imports across all industries was 4.4% and the median was 3.3%. In some specifications, I also use Canadian tariffs on U.S. exports obtained from Trefler (2004). 4.2. Firm-level sample Appendix A provides definitions of all variables used in the paper. The firm-level accounting and stock return data come from Compustat and the Center for Research in Security Prices (CRSP). The sample spans the period from 1983 to 1995 and consists of all U.S.-based publicly traded industrial non-utility firms with available tariff data. The usable sample starts in 1984 because the valuation regression uses yearly changes in variables. Since my empirical analysis exploits the differential exposure of firms to the trade liberalization (level of tariffs on Canadian imports prior to the FTA), my sample includes firms that are present in Compustat at or before 1989. Firm-year observations are required to have non-missing data for book assets, sales, cash, common shareholders' equity, and conform to basic accounting identity. I require firm-year observations to have valid stock returns for an entire fiscal year. I further remove firm-years for which cash holdings exceed the value of total book assets or net asset growth rate exceeds 200%. Since many firms operate in more than one segment, each firm's exposure to the trade liberalization is measured as the sales-weighted average of the Canadian tariffs across the four-digit SIC industries in which the firm was active in 1988. Data on segment sales and the segment's primary four-digit SIC codes are obtained from the Compustat Segments database. Firms that do no have data on segments' SIC code are assigned to the primary SIC code reported by Compustat. Clarke (1989) and Kahle and Walkling (1997) point out that some of the four-digit SIC industry classifications used by Compustat may not accurately identify meaningful product markets. Following these researchers, I retain only firms whose main segment's (in terms of sales) four-digit SIC industry code is assigned to well-defined product markets and exclude firms whose main segment's SIC code ends with zero or nine. The final sample consists of 1033 firms with 12,680 firm-year observations. Table 1 describes the key variables used in this study. All variables are converted to real values in 1990 dollars using the consumer price index and all ratio variables are winsorized at the 1 and 99 percentiles, to reduce the impact of outliers. The median raw and abnormal stock return is 3.9% and − 8.2%. The average changes in cash and earnings are slightly positive, suggesting that firms' cash holdings and operating performance tend to increase over time. 5. Results 5.1. The main result Table 2 reports results of the valuation model described in Eq. (1). Column 1 replicates Faulkender and Wang's (2006) original results to confirm the association between cash holdings and firm value for my sample firms. The results show that the estimated coefficients on all variables are similar to those reported by Faulkender and Wang. To get a better understanding of economic magnitudes, throughout the paper I estimate the total dollar change in the market value of equity as a result of one dollar change in cash balance for the mean firm. So, the coefficient estimates in Column 1 imply that a $1 of extra cash is worth $1.643 to Table 1 Summary Statistics. This table reports summary statistics for the sample, which consists of nonfinancial and nonutility firm-years from 1984 to 1995. Changes are measured as the value of the variable is at the end of fiscal year minus its value at the beginning of fiscal year. See Appendix A for detailed variable definitions. Variable

Mean

Median

Standard deviation

25th percentile

75th percentile

Return Risk-adjusted return Change in cash/ME Change in earnings/ME Change in noncash assets/ME Change in R&D/ME Change in interest expense/ME Change in common dividends/ME Lagged Cash/ME Market Leverage New finance/ME Tariffs on Canadian imports Market-to-book assets Cash/Assets Capital exp./assets Labor–capital ratio Stock correlation with industry index Blockholder ownership No of observations Firms

0.128 −0.002 0.003 0.015 −0.02 0 −0.002 0 0.156 0.242 0.021 0.027 1.359 0.133 0.003 0.121 1.003 0.272 12,680 1033

0.039 −0.082 −0.001 0.006 0.015 0 0 0 0.086 0.191 0 0.023 0.995 0.069 0.001 0.066 0.913 0.236

0.566 0.534 0.128 0.21 0.384 0.021 0.025 0.007 0.207 0.22 0.194 0.031 1.107 0.163 0.056 0.157 1.571 0.209

−0.214 −0.318 −0.035 −0.039 −0.095 0 −0.004 0 0.031 0.048 −0.033 0.004 0.739 0.02 −0.016 0.025 0.314 0.082

0.324 0.175 0.031 0.047 0.11 0.004 0.004 0 0.194 0.383 0.053 0.04 1.515 0.185 0.02 0.145 1.652 0.448

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Table 2 The impact of the 1989 Canada–U.S. FTA tariff cuts on the value of cash holdings using Faulkender and Wang's (2006) return regressions. This table presents coefficient estimates from a difference-in-differences regression of changes in firm value on changes in cash holdings and other variables. The sample period is between 1984 and 1995. The dependent variable is the size and book-to-market adjusted excess stock return for a firm over the fiscal year. ΔXt is notation for the one-year change in the independent variables. All the independent variables, except leverage, are scaled by the lagged market value of equity. See Appendix A for detailed variable definitions. The regressions include year and firm fixed effects. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-firm error term clustering. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

ΔCash

(1)

(2)

(3)

(4)

1.643*** [0.000]

0.874*** [0.000] 0.591** [0.034] 0.217** [0.049] −0.013 [0.882] 0.004 [0.924]

1.544*** [0.000] 0.588** [0.030] 0.127 [0.236] −0.021 [0.811] 0.002 [0.965]

0.495*** [0.000] 0.146*** [0.000] 1.147*** [0.001] −1.283*** [0.000] 0.675 [0.376] 0.846*** [0.000] −1.190*** [0.000] 0.080** [0.049] -0.712*** [0.001] -1.517*** [0.000] 0.076*** [0.000] Yes Yes 12,662 0.404

0.503*** [0.000] 0.138*** [0.000] 1.220*** [0.000] −1.327*** [0.000] 0.938 [0.216] 0.920*** [0.000] −1.194*** [0.000] 0.100** [0.014]

0.496*** [0.000] 0.144*** [0.000] 1.173*** [0.000] −1.291*** [0.000] 0.701 [0.359] 0.844*** [0.000] −1.190*** [0.000] 0.082** [0.043] -0.700*** [0.001] -1.497*** [0.000] 0.076*** [0.000] Yes Yes 12,504 0.404

1.540*** [0.000] 0.608** [0.023] 0.149 [0.198] −0.022 [0.807] 0.012 [0.754] −0.131 [0.443] −0.057** [0.012] 0.495*** [0.000] 0.144*** [0.000] 1.174*** [0.000] −1.309*** [0.000] 0.678 [0.375] 0.840*** [0.000] −1.186*** [0.000] 0.082** [0.043] -0.714*** [0.001] -1.472*** [0.000] 0.074*** [0.000] Yes Yes 12,504 0.405

ΔCash*PostFTA*High Import Tariff ΔCash* PostFTA ΔCash* High Import Tariff PostFTA*High Import Tariff ΔCash*PostFTA*High Export Tariff PostFTA*High Export Tariff ΔEarnings ΔNet assets ΔR&D ΔInterest ΔDividends Lagged cash Market leverage Net financing ΔCash *lagged cash ΔCash *leverage Constant Year fixed effects Firm fixed effects Observations R-squared

0.069*** [0.000] Yes Yes 12,504 0.397

shareholders in the mean firm that has no cash and no debt at the beginning of the fiscal year. However, Table 1 shows that the mean firm in the sample has cash holdings equivalent to 15.6% of the market value of equity at the beginning of the fiscal year and the leverage ratio of 24.2%. A correct measure of the value effect of a one-dollar increase in cash holdings, therefore, requires incorporation of the two additional coefficients on the interactions of the change in cash with cash balance and leverage multiplied by the sample means of these variables. Hence, a one-dollar increase in cash increases shareholder wealth in the mean firm by $1.16 (=$1.643 − $0.712 ∗ 0.156 − $1.517 ∗ 0.242). In the remaining columns of the table, I augment the specification in Model 1 by including additional interaction terms related to the event. Our focus is on the two key interaction terms: ΔCash*PostFTA*HighTariff and ΔCash*PostFTA, which capture the incremental impact of the trade agreement on the marginal value of an extra $1 of cash for the firms that experience relatively large and small tariff reductions on Canadian imports due to the trade reform. In Model 2, I study the effect of the trade liberalization on the value of an additional dollar of cash by suppressing the interactions of the change in cash with the lagged level of cash and with leverage. This specification allows us to observe the effect of the FTA-mandated tariff cuts on the marginal value of cash for the average firm not contaminated by the changes in the value of cash related to changes in the firm's leverage and lagged cash position.3 The results in Column 2 indicate that equity investors 3 A change in competition due to a trade shock is likely to affect firms' cash holdings and leverage ratios (Xu, 2012). I thank an anonymous referee for suggesting this analysis.

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A. Alimov / Journal of Corporate Finance 25 (2014) 122–139 Table 3 The impact of the FTA tariff cuts on the value of cash: Dynamics. This table presents coefficient estimates from a difference-in-differences regression of changes in firm value on changes in cash holdings and other variables. The sample period is between 1984 and 1995. The dependent variable is the size and book-to-market adjusted excess stock return for a firm over the fiscal year. ΔXt is notation for the one-year change in the independent variables. The regression also includes (not reported) interactions of High Import tariff dummy with the three time period dummies. See Appendix A for detailed variable definitions. The regressions include year and firm fixed effects. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-firm error term clustering. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels. (1) ΔCash ΔCash*Before-FTA ΔCash*FTA

1989-90

1987-88

*High Import Tariff

*High Import Tariff

ΔCash*FTAN1990*High Import Tariff ΔCash**Before-FTA ΔCash* FTA1989–90 ΔCash* FTAN1990 ΔEarnings ΔNet assets ΔR&D ΔInterest ΔDividends Lagged cash Market leverage Net Financing ΔCash *lagged cash ΔCash *leverage Constant Year fixed effects Firm fixed effects Observations R-squared

1987–88

1.514*** [0.000] 0.269 [0.476] 0.106 [0.786] 0.744*** [0.010] -0.102 [0.477] 0.092 [0.501] 0.127 [0.332] 0.493*** [0.000] 0.144*** [0.000] 1.157*** [0.001] -1.300*** [0.000] 0.664 [0.382] 0.840*** [0.000] -1.185*** [0.000] 0.080** [0.047] -0.698*** [0.001] -1.414*** [0.000] 0.086*** [0.000] Yes Yes 12,504 0.406

indeed place a significantly higher value on liquidity for the firms experiencing relatively large import tariff reductions due to the FTA and thus most affected by the trade liberalization. The coefficient on ΔCash*PostFTA*High Import Tariff in Column 2 is positive $0.591 and significant at better than the 5% level. In contrast, the coefficient on ΔCash*PostFTA is only $0.217. As discussed above, the regression also includes the other two interaction terms related to the event: ΔCash*High Import Tariff and PostFTA*High Import Tariff. The estimated coefficients on these two interaction variables in this and other columns of Table 2 are close to zero and statistically not distinct from zero. This indicates that, after netting out permanent firm differences as well as controlling for firm characteristics, there are no differences in the value of cash before the event and abnormal stock returns following the event across firms with high vs low level of exposure to the FTA. Model 3 estimates the differential impact of the trade liberalization on the value of corporate cash after allowing the change in cash to vary with the lagged level of cash on hand and with leverage. The addition of these two interaction terms has very little influence on our key inferences. The estimated coefficient corresponding to the interaction of the change in cash with a greater increase in competitive pressure due to the FTA is virtually unchanged: it is positive $0.588 and statistically significant at better than 3%. This evidence thus indicates that the market significantly increases the marginal value of cash for firms experiencing a substantial increase in competitive pressure due to a large FTA mandated-tariff reductions. In stark contrast, the estimate on the

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interaction of the change in cash with the FTA for firms experiencing relatively small FTA-tariff reductions becomes statistically insignificant. This indicates that the trade liberalization has little impact on the value of cash for firms that undergo smaller changes in their competitive environments following the trade reform. All other interaction terms related to the FTA remain statically insignificant. The impact of deep cuts in tariffs on the marginal value of cash is not only statistically significant but economically sizable as well. Using the results in Column 3, we observe that, following the trade liberalization, a $1 of extra cash is worth about $0.59 more for the mean firm experiencing above 5% tariff reductions relative to the mean firm experiencing below 5% tariff reductions. This represents almost a 50 percentage point increase in the marginal value of cash for the mean firm due to an exogenous shock to its competitive landscape. Since the FTA eliminated both import and export tariffs between U.S. and Canada, the trade liberalization potentially enhanced export opportunities to Canada for some U.S. firms. To separate effects of market expansion opportunities from the increase in competitive pressure in domestic markets, Model 4 includes an additional interaction term of the change in cash with the post-FTA indicator variable and the dummy variable for firms that faced relatively high Canadian tariffs on U.S. exports (in excess of 5%) before the FTA, ΔCash*PostFTA*High Export Tariff. The high export tariff dummy is computed in an analogous way to the high import tariff dummy. The results in Column 4 show that a large fall in Canadian export tariffs does not influence the market valuation of cash. The addition of the firms' exposure to high export tariffs actually strengthens my earlier inferences about the effect of the large import tariff reductions on the value of cash: the coefficient on ΔCash*PostFTA*High Import Tariff increases to $0.61 (p-value is 0.023). Thus, investors appear to revise their valuation of the cash reserves mainly in response to an increase in competition due to a fall in entry barriers for foreign competitors rather than an increase in potential Canadian market expansion opportunities. Next, I address issues of reverse causality. As was discussed before, reverse causality issues appear to be minimal in this analysis since the passage of the trade agreement was relatively unexpected and not driven by macroeconomic shocks. Nevertheless, I examine reverse causality in Table 3 by tracing out the timing of the effect of the trade liberalization on the value of cash. To investigate the intertemporal dynamics, I follow Bertrand and Mullainathan (2003) and decompose the PostFTA dummy into three separate dummies: (i) Before-FTA 1987–88 is a dummy for observations in years 1987 and 1988, which captures any effects from two years before to one year before the trade liberalization; (ii) FTA1989–90 is a dummy for observations in years 1989 and 1990, which captures the effect in the year FTA was passed and the year after; and (iii) After FTAN1990 is a dummy for observations after 1990, which captures the effect two years after the implementation of the FTA. I then interact these three dummy variables with my key variables — ΔCash and ΔCash*High Import Tariff. If the coefficient on the triple interaction variable ΔCash*Before-FTA1987–88*High Import Tariff is positive and significant, that may indicate potential reverse causality. I also include but, in the interest of brevity, do not report the coefficients on the interaction of High Import Tariff with these three time period dummies. The results in Table 3 show that the coefficient estimates on the ΔCash*Before-FTA1987–88*High Import Tariff and ΔCash*FTA1989–90*High Tariff interaction variables are not statistically different from zero. This suggests that the pre-existing patterns in the valuation of cash do not explain the timing of the trade reform. In contrast, the coefficient estimate on ΔCash*After FTAN1990* High Import Tariff is highly statistically significant and even larger in magnitude than the estimate on ΔCash*PostFTA*High Import Tariff in Table 2. This finding is consistent with a causal interpretation of the main result: investors place a higher value on internal liquidity for firms that face increased competitive pressure due to a large decline in tariffs on Canadian imports brought about the trade liberalization. In unreported tests, I examine the robustness of the results to an alternative valuation regression developed by Fama and French (1998) and modified by Dittmar and Mahrt-Smith (2007) and Bates et al. (2009). The Fama and French methodology allows me to examine how the increase in competitive pressure affects the contribution of a firm's cash reserves to its market-to-book assets ratio. The results are consistent with those in Tables 2 and 3 and suggest that, following the trade liberalization, the contribution of cash holdings to the market-to-book ratio increases more for the firms that experience large tariff changes than for those firms that experience small tariff changes due to the FTA. To summarize, the main conclusion from Tables 2 and 3 is that, following the removal of trade barriers between Canada and U.S., investors place a higher value on the cash holdings of firms most likely to be affected by the trade liberalization (i.e. firms protected by higher U.S. tariffs on Canadian imports prior to 1989). To provide further insights into the effects of the trade liberalization, the next section attempts to identify the potential economic mechanisms through which increased foreign competition might affect the market value of corporate cash reserves. 5.2. Potential mechanisms The observed positive value impact of an increase in competitive pressure due to the tariff reductions is consistent with both the predation threat and agency explanations. However, the predation threat and agency arguments suggest that an increase in competitive pressure impacts the value of cash through two distinct mechanisms. According to the predation view, a shock to firms' competitive environment raises the value of internal liquidity because cash provides flexibility and allows firms to react more aggressively to new competitive threats. Under this view, one might expect the trade liberalization to lead to a particularly greater increase in the value of cash among firms most likely to be exposed to the threat of predation, such as firms that share a larger proportion of its growth opportunities with existing rivals. In contrast, the agency hypothesis suggests that an increase in competition raises the value of cash by acting as a disciplinary mechanism that forces managers to improve efficiency in utilizing

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cash resources. Under the agency view, therefore, one might expect that the effect of the trade agreement on the value of cash will be stronger for firms with more entrenched managers, such as firms that have weaker governance mechanisms in place. To determine the relative merits of these two explanations, the next analyses attempt to distinguish whether the effect of the foreign competition shock varies systematically across firms that differ along various dimensions that proxy for predation threat and governance prior to the passage of the FTA. Note that, as suggested by Bertrand and Mullainathan (1999), I use the level of predation threat and governance measured before the trade agreement in order to avoid future changes in predation threat and governance that may be endogenous to the FTA. 5.2.1. Test of predation threat channel Froot et al. (1993) propose that a firm's exposure to the threat of predatory actions is largely determined by the degree of the interdependence of its investment opportunities with product market rivals. I follow Haushalter et al. (2007) and measure the degree of the interdependence of a firm's investment opportunities using two different proxy variables. The first proxy is the absolute value of the deviation of a firm's capital-to-labor ratio from the median ratio in its four (or three) digit SIC industry, measured in 1988. Smaller values of the capital-to-labor ratio deviation indicate that a firm uses production technology that is more similar to the rest of the industry and thus faces a greater risk of losing investment opportunities to rivals (e.g. MacKay and Phillips, 2005). The second proxy is the correlation of a firm's monthly stock returns with respect to an equally-weighted industry return index. The industry index is constructed using returns of its competitors sharing the same three-digit SIC code. Using the two-digit SIC code instead of three-digit SIC code to construct the industry index leads to similar conclusions. The correlation measure is estimated over the three year period prior to the FTA. The higher value of the correlation indicates that a firm's growth opportunities co-vary more with those of their industry rivals. Following the prior studies (e.g. Fresard, 2010), in order to make these industry-based measures meaningful, the sample includes only firms that have a minimum of 10 competitors in their industry. These competitors are further required to have valid data on the number of employees to construct the capital-to-labor ratio and at least 12 months of stock returns to be included in the industry index. These additional data requirement reduce the sample size relative to the main tests above. Table 4 presents estimates of Eq. (1) separately for firms exposed to high and low threat of predation. Firms are assigned to a high (low) predation threat group if their capital-to-labor ratio falls in the lower (upper) third or their stock return correlation falls in the upper (lower) third of the distribution for these measures. The middle tercile is discarded. The predation view predicts that the estimate on ΔCash*PostFTA*High Import Tariff will be larger for firms exposed to greater predation risk due to the interdependence of their investment opportunities with rivals. The evidence in Table 4 is consistent with a magnifying effect of the predation threat on the change in the marginal value of cash for firms experiencing a greater increase in foreign competition due to large tariff cuts. Across both proxies for predation risk, I find that the coefficients on ΔCash*PostFTA*High Tariff are positive and statistically significant for firms in the high predation risk group. In stark contrast, the increase in foreign competition due to a fall in tariffs does not affect the marginal value of cash for firms facing lower threat of predation. The difference between the coefficients across the high and low predation risk groups is significant at better than the 10% level.4 Notably, the trade liberalization does not affect the value of cash for firms experiencing relatively small tariff reductions regardless of their exposure to predation risk (slope on ΔCash*PostFTA). Hence, the regression estimates suggest that, following the liberalization, a one-dollar increase in cash increases shareholder value substantially more for the firms experiencing relatively large tariff cuts and facing greater predation threats. These results are consistent with the implications of predation theories: when competition intensifies, internal liquidity becomes more valuable for those firms that are most exposed to potential competitive threats by new foreign rivals. 5.2.2. Test of agency hypothesis I measure the extent of agency problems at the firm using two proxies based on institutional monitoring. The anti-takeover index developed Gompers et al. (2003), a commonly used measure of managerial entrenchment, is not available during my sample period. Following Dittmar and Mahrt-Smith (2007), I measure governance at the firm using ownership positions of institutional blockholders and public pension funds. The corporate governance literature argues that blockholders and pension funds have both incentives and ability to affect the governance of the firm and thus limit the scope of managerial agency problem. For example, Shleifer and Vishny (1986, 1997) suggest that large institutional blockholders have strong incentives to engage in costly monitoring of the management. Del Guercio and Hawkins (1999) and Gillan and Starks (2000), suggest that public pension funds tend to be activist institutional investors due to their long-term focus and hence have strong incentives to monitor and discipline managers of firms in their portfolio. I measure block institutional and pension fund ownership as the sum of all ownership positions by blockholders and public pension funds. A larger ownership stake controlled by institutional blockholders and pension funds would indicate more oversight of managers and hence potentially lower managerial agency problem at the firm. The data on institutional ownership come from the 1988 SEC 13f filings recorded in the Thompson Reuters database. I identify public pension funds using the manager numbers provided by Dittmar and Mahrt-Smith (2007). An institutional blockholders is an institutional investor that holds ownership stake in a firm greater than 5%. Missing blockholder holdings are set to zero if the reported total institutional holdings 4 I assess the significance of the difference in the coefficients between the two regressions using a stacked regression framework. Specifically, I create a dummy variable for high predation risk and interact it with every independent variable.

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Table 4 The impact of the FTA tariff cuts on the value of cash for firms facing high vs low predatory threats. This table presents coefficient estimates from a difference-in-differences regression of changes in firm value on changes in cash holdings and other variables. The sample period is between 1984 and 1995. The dependent variable is the size and book-to-market adjusted excess stock return for a firm over the fiscal year. ΔXt is notation for the one-year change in the independent variables. See Appendix A for detailed variable definitions. The regressions are estimated separately for firms facing high and low exposure to the threat of predation. The threat of predation for each firm is measured based on: (i) the absolute value of the deviation of a firm's capital-to-labor ratio from the median ratio in its industry and (ii) correlation of a firm's monthly stock returns with respect to an equally-weighted industry return index. The regressions include year and firm fixed effects. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-firm error clustering. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. Threat of predation measured as

ΔCash*PostFTA*High Import Tariff p-value of difference ΔCash*PostFTA p-value of difference ΔCash p-value of difference ΔCash*High Import Tariff PostFTA*High Import Tariff ΔEarnings ΔNet assets ΔR&D ΔInterest ΔDividends Lagged cash Market leverage Net financing ΔCash *lagged cash ΔCash *leverage Constant Year fixed effects Firm fixed effects Observations R-squared

Absolute value of capital to-labor ratio

Correlation of firm returns with industry returns

High

High

Low

Low

threat

threat

threat

threat

1.675*** [0.004] [0.08] 0.063 [0.757] [0.230] 1.591*** [0.000] [0.540] −0.122 [0.756] −0.069 [0.295] 0.520*** [0.000] 0.165*** [0.001] 0.945 [0.161] −1.063* [0.055] −0.054 [0.967] 0.885*** [0.000] −1.19*** [0.000] 0.024 [0.758] −0.408 [0.288] −1.85*** [0.000] 0.088** [0.011] Yes Yes 2732 0.341

0.651 [0.254]

0.517* [0.064] [0.041] 0.064 [0.727] [0.917] 1.821*** [0.000] [0.255] 0.674 [0.152] 0.061 [0.388] 0.539*** [0.000] 0.168*** [0.001] 1.078** [0.034] −1.568*** [0.007] −0.182 [0.910] 0.943*** [0.000] −1.200*** [0.000] 0.021 [0.808] −0.708* [0.095] −1.764*** [0.000] 0.032 [0.314] Yes Yes 3123 0.4

0.223 [0.207]

−0.198 [0.333] 1.156*** [0.000] −0.011 [0.980] 0.053 [0.450] 0.567*** [0.000] 0.069 [0.146] 1.430** [0.032] −1.69*** [0.008] 1.584 [0.281] 0.618*** [0.000] −1.10*** [0.000] 0.146* [0.081] −0.539 [0.198] −0.722 [0.182] 0.112*** [0.002] Yes Yes 2864 0.325

0.036 [0.867] 1.412*** [0.000] −0.078 [0.839] −0.066 [0.285] 0.599*** [0.000] 0.121** [0.013] 1.993*** [0.001] −0.683 [0.281] 0.906 [0.469] 0.702*** [0.000] −1.243*** [0.000] 0.103 [0.198] −0.696* [0.054] −1.333*** [0.001] 0.120*** [0.001] Yes Yes 3227 0.341

for those firm-year observations are positive. Similar to the previous test, the additional requirement that a firm has valid data on institutional holdings reduces the sample size relative to the main tests. Table 5 reports the estimates from Eq. (1) separately for firms with high and low block institutional ownership (Columns 1 and 2) and high and low pension fund ownership terciles (Columns 3 and 4). The middle tercile is discarded. A key finding in Table 5 is that the main variable of interest – ΔCash*PostFTA*High Import Tariff – yields positive but not significant (at the conventional levels) coefficients in the sample of firms with low blockholder and pension fund ownership (p-values are 0.197 and 0.132, respectively). The differences in estimates across the high and low blockholder and pension fund ownership terciles are also not statistically significant. Thus, the estimates do not support the agency argument that a rise in competition increases the value of cash only when firms can benefit from better governance. To summarize, the main conclusion from Tables 4 and 5 is that the increase in the marginal value of cash for firms experiencing a greater increase in competitive pressure is mostly concentrated among firms that likely faced greater product market threats

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Table 5 The impact of the FTA tariff cuts on the value of cash for firms with strong vs weak governance. This table presents coefficient estimates from a difference-in-differences regression of changes in firm value on changes in cash holdings and other variables. The sample period is between 1984 and 1995. The dependent variable is the size and book-to-market adjusted excess stock return for a firm over the fiscal year. ΔXt is notation for the one-year change in the independent variables. See Appendix A for detailed variable definitions. The regressions are estimated separately for firms with strong vs weak governance, measured using the level of block institutional ownership and public pension fund ownership. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-firm error clustering. The regressions include year and firm fixed effects. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. Governance measured as Blockholder

Pension fund

Ownership

ΔCash*PostFTA*High Import Tariff p-value of difference ΔCash*PostFTA p-value of difference ΔCash p-value of difference ΔCash* High Import Tariff PostFTA*High Import Tariff ΔEarnings ΔNet assets ΔR&D ΔInterest ΔDividends Lagged cash Market leverage Net financing ΔCash *lagged cash ΔCash *leverage Constant Year fixed effects Firm fixed effects Observations R-squared

Ownership

High

Low

High

Low

0.615 [0.414] [0.519] −0.085 [0.680] [0.978] 1.450*** [0.000] [0.283] 0.23 [0.605] 0.09 [0.176] 0.487*** [0.000] 0.157*** [0.002] 1.626*** [0.003] −1.786*** [0.002] 1.058 [0.514] 0.715*** [0.000] −0.930*** [0.000] 0.009 [0.909] −0.823* [0.078] −1.209** [0.026] 0.036 [0.227] Yes Yes 2960 0.343

0.241 [0.197]

0.543 [0.480] [0.406] −0.257 [0.243] [0.606] 1.649*** [0.000] [0.831] 0.146 [0.733] −0.008 [0.906] 0.589*** [0.000] 0.237*** [0.000] 1.419** [0.023] −1.962*** [0.002] −0.736 [0.550] 0.797*** [0.000] −0.980*** [0.000] −0.106 [0.251] −0.738 [0.178] −1.222** [0.042] 0.007 [0.824] Yes Yes 2935 0.352

0.781 [0.132]

−0.087 [0.569] 1.423*** [0.000] 0.165 [0.616] −0.047 [0.447] 0.486*** [0.000] 0.127*** [0.000] 1.030* [0.051] −1.224*** [0.003] 2.332** [0.032] 0.718*** [0.000] −1.189*** [0.000] 0.08 [0.168] −0.443 [0.131] −1.242*** [0.000] 0.119*** [0.000] Yes Yes 5026 0.345

−0.075 [0.669] 1.512*** [0.000] 0.543 [0.480] 0.037 [0.564] 0.481*** [0.000] 0.201*** [0.000] 1.349** [0.023] −1.825*** [0.000] 3.015** [0.013] 0.782*** [0.000] −1.131*** [0.000] 0.098 [0.182] −0.374 [0.229] −1.407*** [0.000] 0.059 [0.107] Yes Yes 2905 0.357

prior to the FTA. This evidence is thus more consistent with the predation threat theories and suggests that the market impounds an expected increase in the competitive threats following the trade liberalization into its valuation of firm cash holdings.

5.2.3. Additional analysis: changes in the use of cash holdings Since the value of firms' cash reserves is ultimately determined by how the market expects that cash to be used, changes in the value of cash should be reflected in the ex-post use of cash resources. While it is beyond the scope of the paper to try to fully identify all possible changes in how firms deploy their cash reserves, in this section I look at changes in one potential use of cash: spending it on investment.5 I focus on the change in the use of cash for investment following a rise in competition because it is one potential dimension along which the predictions of the agency and predation risk hypotheses clearly differ. Under the predation view, one may expect that, on average, firms will respond to a rise in competitive pressure by increasing spending on certain types of investment that can help the firm to mitigate increased predatory threats (e.g. Haushalter et al., 2007). In contrast, the 5

In a working paper, Frezard and Valta (2012) also examine changes in firms' capital and R&D expenditures following large import tariff cuts.

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agency hypothesis predicts a decline in spending following a rise in competitive pressure since competition can curb opportunistic managerial behavior such as wasteful spending. As in the prior analyses, my primary identification strategy focuses on the differential post-FTA changes in the use of cash reserves on investment across firms with high vs low levels of tariffs on Canadian imports prior to 1989. Changes in investment are measured as changes in capital expenditures, research and development (R&D), advertisement, and acquisition spending. I estimate the following augmented version of the investment specification used by Harford et al. (2008): ΔInvestmentit ¼ a þ γ1 postFTA  HighTarif i þ γ 2 postFTA  HighTarif f i  Cashi;t‐2 þγ 4 postFTA  Cashi;t‐2 þ γ 5 Cashi;t‐2 þ γ6 Q i;t‐2 þ γ 7 Controlsi;t‐2 þ eij;t

ð2Þ

where i indexes the firm and t is a year index. The dependent variable is year-to-year change in capital expenditures, research and development (R&D), advertisement, and acquisitions, all scaled by beginning-of-year total assets. I use the Compustat data to compute changes in capital expenditures, R&D and advertisement expenditures (where available) and the merger and acquisitions data from Thomson Financial to compute changes in acquisition spending. The key variable of interest is the firm's cash balance (scaled by total assets) and its interaction with the firm's sensitivity to the level of FTA-mandated tariff reductions. Control variables include Tobin's Q (market to book assets) as a measure of growth opportunities, cash flow to total assets, size of firm's book assets, book leverage, a dividend dummy indicating firms paying common dividend. As in Harford et al. (2008), the specifications include year and firm's main four-digit SIC industry fixed effects. Because the contemporaneous levels of both investment and cash holdings can be simultaneously determined, I use changes in investment instead of levels and employ two-year lagged values of cash holdings, Tobin's Q and other independent variables. The results of this analysis are presented in Table 6. As expected, the Tobin's Q and operating cash flow variables tend to yield positive and significant coefficients in most specifications. This indicates that firms with better growth opportunities and greater internal liquidity tend to spend more on discretionary investment. The estimated coefficient on Cash*PostFTA*High Import Tariff is

Table 6 The impact of the FTA tariff cuts on the use of cash for investment. This table presents coefficient estimates from a difference-in-differences regression of changes in firms' investment on lagged cash holdings, market-to-book assets, cash flow and other variables. The sample period is between 1984 and 1995. The dependent variables are the change in capital expenditures, R&D and advertising expenditures (for firms with available R&D and advertising expenditures), and acquisitions, all scaled by lagged total assets. See Appendix A for detailed variable definitions. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-industry error clustering. The regressions include year and firms' main four-digit SIC industry fixed effects. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. Changes in spending on

Cash*PostFTA*High Import Tariff Cash*PostFTA PostFTA*High Import Tariff Cash*High Import Tariff PostFTA Cash/assetst = -2 Market-to-book assets Operating cash flow Log book assets

t = -2

t = -2

Dividend indicator Debt/assets

t = -2

t = -2

t = -2

Constant Year fixed effects Industry fixed effects Observations R-squared

Capital expend

ΔR&D expend.

ΔAdvertisement

Δ Acquisitions

0.019* [0.057] −0.004 [0.540] −0.002 [0.527] −0.007 [0.238] −0.012* [0.053] 0.001 [0.872] 0 [0.871] 0.011** [0.031] −0.001** [0.014] 0.004*** [0.000] −0.003 [0.405] 0.018*** [0.000] Yes Yes 9860 0.026

0.022* [0.055] 0.001 [0.926] −0.003 [0.251] −0.003 [0.315] −0.004** [0.029] 0.009** [0.025] 0.002*** [0.007] 0.049*** [0.000] 0 [0.964] −0.001* [0.094] 0.004* [0.057] 0.001 [0.744] Yes Yes 6318 0.082

−0.003 [0.721] 0.007 [0.142] −0.001 [0.513] −0.001 [0.292] 0 [0.839] −0.002 [0.373] 0 [0.580] 0.005 [0.172] 0 [0.248] 0.003** [0.018] −0.006*** [0.009] 0.004*** [0.001] Yes Yes 3229 0.116

0.004 [0.781] 0.003 [0.496] −0.006** [0.011] 0.001 [0.234] −0.001 [0.588] −0.009** [0.021] 0.001 [0.103] −0.003 [0.663] 0 [0.108] −0.001 [0.287] −0.003 [0.238] 0 [0.830] Yes Yes 9864 0.006

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Table 7 Competition and the value of cash: large sample analysis. This table presents coefficient estimates from a regression of changes in firm value on changes in cash holdings and other variables. The sample period is between 1976 and 2005 in Columns (1) and (2) and between 1997 and 2007 in Columns (3) and (4). The dependent variable is the size and book-to-market adjusted excess stock return for a firm over the fiscal year. ΔXt is notation for the one-year change in the independent variables. See Appendix A for detailed variable definitions. The regressions include year and firm fixed effects. Standard errors in brackets below coefficients are computed adjusting for heteroskedasticity and within-firm error term clustering. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels.

ΔCash *Log(Herfindahl–Hirschman) Log(Herfindahl–Hirschman index)

(1)

(2)

−0.480*** [0.000] 0.054*** [0.002]

−0.225*** [0.001] 0.049*** [0.004]

ΔCash *Log(product fluidity) Log(product fluidity) ΔCash ΔEarnings ΔNet assets ΔR&D ΔInterest ΔDividends Lagged cash Market leverage Net financing

4.110*** [0.000] 0.614*** [0.000] 0.176*** [0.000] 0.923*** [0.000] −1.588*** [0.000] 2.045*** [0.000] 0.818*** [0.000] −1.058*** [0.000] 0.110*** [0.000]

ΔCash *lagged cash ΔCash *leverage Constant Year fixed effects Firm fixed effects Observations R-squared

−0.338*** [0.002] Yes Yes 73,509 0.353

3.218*** [0.000] 0.609*** [0.000] 0.183*** [0.000] 0.866*** [0.000] −1.525*** [0.000] 2.001*** [0.000] 0.742*** [0.000] −1.049*** [0.000] 0.085*** [0.000] −0.770*** [0.000] −1.721*** [0.000] −0.298*** [0.006] Yes Yes 73,509 0.363

(3)

(4)

0.431*** [0.000] 0.005 [0.783] 0.699*** [0.000] 0.573*** [0.000] 0.176*** [0.000] 0.683** [0.015] −1.566*** [0.000] 1.747*** [0.008] 1.305*** [0.000] −1.502*** [0.000] 0.086** [0.020]

0.294*** [0.002] 0.007 [0.720] 1.660*** [0.000] 0.567*** [0.000] 0.181*** [0.000] 0.647** [0.020] −1.432*** [0.000] 1.732*** [0.008] 1.231*** [0.000] −1.492*** [0.000] 0.064* [0.077] −0.795*** [0.000] −2.016*** [0.000] 0.094** [0.014] Yes Yes 32,552 0.426

0.092** [0.017] Yes Yes 32,552 0.418

a positive and statistically significant in the capital expenditures and R&D spending specifications. This indicates that, following the trade liberalization, firms experiencing a greater increase in competitive pressure (i.e. large tariff cuts) are more likely to spend their existing cash balances on capital and R&D expenditures. In contrast, the coefficient on the interaction of cash holdings with the post-FTA dummy is not significant, indicating that firms that experience relatively small changes in tariffs due to the FTA do not increase the use of cash for investment purposes. The observed positive association of lagged cash balances and the post-FTA investment of firms with larger tariff cuts suggests that, on average, firms that experience a greater rise in competitive pressure tend to increase their spending on capital and R&D expenditures. Therefore, the results here are also more consistent with the predation threat story. However, it is important to acknowledge a caveat to this last set of results. The test design is not able to directly attribute the increased spending of cash to the firm's deliberate attempt to manage increased predatory threats.6 Therefore, the results of the analysis of cash usage should be viewed as suggestive and not conclusive.

5.2.4. Generalization of the results It is important to note another important caveat that applies to the results of this as well as other studies that exploit a quasi-natural experiment as an identification strategy. A significant advantage of exploiting the trade reform as a plausible exogenous shock to competition is that it helps mitigate concerns over endogeneity and thus increases our confidence in the findings. However, it does naturally raise a question as to whether my inferences about the effect of increased competition on the

6

I thank the referee for pointing out the limitation of this part of the analysis.

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market value of cash could be extrapolated beyond this particular setting. To address such concerns, in this section I re-examine the relation between the intensity of product market competition and the value of corporate cash using a large panel of Compustat firms. I measure the degree of competition in product markets using two recently developed proxies. The first measure is the fitted Herfindahl–Hirschman Index (HHI) from Hoberg and Phillips (2010), which reflects the concentration ratio of an industry. Hoberg and Phillips calculate the fitted HHI for each three-digit SIC industry in each year between 1975 and 2005 by combining the data for public and private firms from the Census Bureau, Compustat, and the Bureau of Labor Statistics. A higher value of the fitted HHI indicates a more concentrated industry and hence potentially lower level of competition. The second measure is product market fluidity from Hoberg et al. (forthcoming), which reflects changes in a firm's product space due to moves made by the firm's product market competitors. A higher value of fluidity indicates that a firm faces greater competitive threats in its product markets. The product market fluidity measure is available for the years 1997 to 2007. Table 7 examines the association between the value of cash and product market competition using each proxy for competition in a separate regression. The structure of the table is similar to Table 2. In Columns 1 and Columns 3, I study the relation between each different measure of competition and the value of cash by suppressing the interactions of the change in cash with the lagged level of cash and with leverage. Columns 2 and Columns 4 then add these additional interaction terms. The regressions include both year and firm fixed effects. Thus, the identification again comes from within-firm variation in the intensity of competition in product markets. The estimated coefficients on the interaction between the change in cash and the natural log of the HHI in Columns 1 and Columns 2 are negative and the coefficients on the interaction between the change in cash and the natural log of product market fluidity in Columns 3 and 4 are positive. All these estimates are significant at better than 1%. These results indicate that the market value of cash is positively related to variation in the intensity of competition faced by the average firm in its product markets. These results indicate that my inferences about the impact of greater competition on the value of cash from the quasi-natural experiment apply more broadly to a large sample of Compustat firms. For additional analysis using these and other alternative proxies for competition, I refer the interested reader to an older version of this paper available on my SSRN author page.

6. Conclusions Using the 1989 Canada–United States Free Trade Agreement as a source of exogenous variation in product market conditions, I establish a causal effect between increased foreign competition and the value that shareholders place on the cash holdings of firms. I find that following the shock to firms' competitive environment, the market value of cash increases significantly for firms most affected by the decline in entry barriers into their product markets (measured by the level of tariff cuts on Canadian imports). The effect of the tariff cuts on the value of cash manifests only two years after the trade liberalization. These results suggest that the intensity of competition plays an economically important and causal role in determining the value of cash to firms and their shareholders. I further find that the increased competitive pressure has a stronger impact on the marginal value of cash for the firms facing greater risk of losing investment opportunities to competitors. I also document that, following the trade liberalization, firms experiencing a greater increase in competitive pressure tend to spend more of their cash balances on capital and R&D expenditures, probably in an attempt to combat new competitive threats by their rival firms. Finally, using alternative proxies for competition, I demonstrate that the inferences from the quasi-natural experiment also apply to a large sample of Compustat firms. This paper represents an important step in our understanding of the value implications of changes in firms' competitive environments. Although this study focuses only on the causal impact of changes in competition on the market value of cash, increased competition is likely to influence investors' valuation of other firm polices and resources as well. I look forward to future research on these and other related issues.

Appendix A. Variables definition Name of variables Valuation regression variables Assets Cash Earnings Market value of equity Market to book Net assets R&D expenses Interest Dividends Market leverage

Description (Compustat data names in parentheses) Book assets (at) Cash and short-term investments (che) Earnings before Extraordinary Items (ib + xint + txdi + itci) Stock price (prcc_f)*Shares outstanding (csho) Book assets (at) + market value of common equity (prcc_f*csho) − book value common equity (ceq) − deferred taxes (txdb)) / (book assets (at) Book assets (at) − cash and short-term investment (che). Research and development (xrd) Interest expenses (xint) Common dividends (dvc) (debt in current liabilities (dlc) + long − term debt (dltt))/(market value of equity + dlc + dltt)

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Appendix A (continued) Name of variables

Description (Compustat data names in parentheses)

Net new finance

Sales of common and preferred stock − stock repurchases + issuance of long-term debt-long-term debt reduction (sstk-prstkc + dltis-dltr) Stock return over the fiscal year (from CRSP) minus Fama and French size and book-to-market matched portfolio return

Risk-adjusted return Trade and other measures Tariffs on Canadian imports

Duties collected by the U.S. customs divided by total customs value of imports from Canada at the four-digit SIC industry level averaged over the 3-year period between 1986 and 1988. Trade data is from Center for International Data at the University of California Davis. High import tariff Binary variable indicating that a firm is experiencing a fall in tariff on Canadian imports in excess of 5% (roughly corresponding to the top third of tariff distribution) following the FTA implementation in 1989. For each firm, the tariff reduction is computed as the sales-weighted average across all is business segments that a firm was active in 1988. Segment data is from Compustat Segments. Capital–labor ratio Gross PPE (ppegt) divided by number of employees (emp) Correlation with industry The correlation coefficient between the firm's monthly stock returns and average industry returns returns after controlling for the market returns for the period between 1986 and 1988 Block institutional ownership Percentage of firm's shares held by institutional blockholders as reported in Thomson–Reuters Institutional Holdings Database Pension fund ownership Percentage of firm's shares held by public pension funds as reported in Thomson–Reuters Institutional Holdings Database. The names and manager numbers of public pension funds are provided by Dittmar and Mahrt-Smith (2007). Fitted Herfindahl–Hirschman A measure of industry competition at 3-digit SIC level. Developed by Hoberg and Phillips (2010). It and combines index (HHI) Compustat based HHI, with HHI from the Commerce Department and employee data from the Bureau of Labor Statistics. Product fluidity A measure of firm-level competitive threats based on the description of firms' product space and rival moves in their 10-K's developed by Hoberg et al. (forthcoming). Both Fitted HHI and product fluidity measures are available on on http://www.rhsmith.umd.edu/industrydata/

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